Appendix B – Product-Service Systems

Definition of Product-Service Systems

In order to create a clear picture of what is meant by a Product-Service System, the definition of van Ostaeyen (2014) is used, which is in line with Beuren, Ferreire & Miguel (2013) and Sassenelli, Pezzotta, Rossi, Terzi, & Cavalieri (2015):

‘A Product-Service System (PSS) is an integrated offering of products and services with a revenue mechanism that is based on selling availability, usage or performance’

Product-Service Systems Types

Besides a clear definition of a PSS, it is clear that there are different PSS typologies (van Ostaeyen, 2014). It is important that the categorisation is clear, because it can have a large impact on whether PSS is successful and a good transformation enabler for CE, or not. Van Ostaeyen (2014) defines three different PSS types, which are widely accepted within the academic PSS literature (Van Ostaeyen, Van Horenbeek, Pintelon, & Duflou, 2013):

1. Product-oriented PSS 2. Use-oriented PSS 3. Result-oriented PSS

It is important with the focus on sustainable development to understand the differences between these three types. Because using a PSS concept does not automatically produce sustainable development (Guidat, Barquet, Widera, Rozenfeld, & Seliger, 2014) (Kuijken, Gemser, & Wijnberg, 2016) (Pigosso & McAloone, 2015) (Sousa & Cauchick Miguel, 2015).

The first type, product-oriented, the ownership of the product is transferred to the customer. The transfer of ownership is not optimal and thus product-oriented PSS is unsuitable for enabling the transition towards CE. This is underpinned by van Ostaeyen (2014), who also stated that this transfer of ownership discerns it from the other two types of PSS. It is still focussed on selling the largest amount of products, which in itself is certainly not the most sustainable solution (Costa, Prendeville, Beverley, Teso, & Brooker, 2015) (Schweitzer & Aurich, 2010).

With a use-oriented PSS, the ownership remains at the producer of the product and the right to use the product are sold to the customer. Classic use-oriented PSS is for instance the leasing of products. Although this might seem like a sustainable development, it can often produce a counter effect which cancels out any environmental advantages (Scheepens, Vogtländer, & Brezet, 2016)s. For instance, lease cars are not driven with greater fuel efficiency or greater care, because the customer does not bear the direct cost or benefit of doing so (Aurich, Mannweiler, & Schweitzer, 2010) (Costa, Prendeville, Beverley, Teso, & Brooker, 2015) (Schweitzer & Aurich, 2010).

The last type is a result-oriented PSS. As stated earlier, PSS does not automatically provide sustainable development. The PSS concept should create the need for sustainability, that it is beneficial for both the manufacturer as well as the customer. Tukker (2015) indicates that only result-oriented is able to fulfil this sustainable development, because with a result-oriented PSS not a product is sold, but functionality (Van Ostaeyen, Van Horenbeek, Pintelon, & Duflou, 2013). It is performance driven and the ownership remains with the manufacturer, who is responsible for the product throughout the life cycle. This means that the disposal is the responsibility of the manufacturing, who then has a strong incentive for reduction of resource usage, reuse of products and the recycling during the disposal phase (Ghisellini, Cialani, & Ulgiati, 2015) (Beuren, Ferreire, & Miguel, 2013) (Fernandes de Castro Rodrigues, Nappi, & Rozenfeld, 2014). Performance agreements could include more than just

functional performance, for instance sustainability targets. Furthermore, all materials and consumables needed for delivering the performance are now cost factors for the manufacturer, it therefore it has a stronger incentive to reduce the use of those resources (Tukker, 2015), which is positive because, as stated in (1.1.2.2), reduction is one of the key principles of CE in terms of sustainability.

Benefits, barriers and best practices of Product-Service Systems

Benefits

Result-oriented PSS may benefit consumer, supplier, the environment and society as a whole in a variety of ways. Due to the lasting relationship between customer and supplier, the potential to continuously improve performance, competitiveness and environmental performance. If successfully, this could lead to a long lasting relationship and alliance which benefit both and cause a win-win scenario (Beuren et al., 2013). In turn, this will lead to high quality assets and customer satisfaction (Aurich et al., 2010). Due to the good relationship, new innovations and systems are more easily developed with the customer involved (Tukker, 2015). Furthermore, by better quality, longer lifetime of the product/asset and the incentive for smart disposal, the amount of waste can be reduced. This reduces the need for new material for new products and increases the usage of old products. Which is one of the pillars of circular economy (Baines et al., 2007). Lastly, PSS has the potential to break the link between production volume and profit, therefore seamlessly supporting what circular economy tries to achieve (Pigosso & McAloone, 2015).

Barriers

Besides the benefits, there are also barriers which have to be overcome in order to implement a PSS successfully (Kimita, Watanbe, Hara, & Komoto, 2015). The whole process of a PSS compared to traditional buying of a product is different. It requires a change of all stakeholders involved in the process, especially due to the increased involvement in one another. Responsibilities shift, dependency increases, financial risks changes and information exchange increase (Beuren et al., 2013) (Schnürmacher, Haka, & Stark, 2015) (Lockett, Johnson, Evans, & Bastl, 2011) (Witjes & Lozano, 2016). The increased dependency can also be interpreted by the customer as a perceived loss of know-how (Gesing, Maiwald, Wieseke, & Sturm, 2014). However, the biggest barrier is, as always, the cultural barrier within an organisation (Schmidt, Malaschewski, Fluhr, & Mörtl, 2015) (Voigt, 2015). In the case of Schiphol, Schiphol has to move away from the practise of full ownership of an asset towards an user of an asset and being able to steer on performance. This requires a focus on the use of the product/asset together with a clear view of the planning of the service needed (Moser, Maisenbacher, Kasperek, & Maurer, 2015). The last barrier which exists within organisations is that the value of a PSS compared to a traditional way of purchasing an asset, is hard to show upfront and on the short term (Kuijken, Gemser, & Wijnberg, 2016).

Procurement

The last thing which may cause a problem is the traditional way of procurement, which is standardised in the EU Public Procurement Directive, which is also applied within Schiphol with projects larger than predetermined amounts, depending on which main contract the project is within. The traditional procurement process, as is also present at Schiphol, can be schematically seen in Figure 1.5.

Supplier Selection Stakeholder demand inventory and selection Procurer Supplier Definition of product or service Criteria specification Selection of suppliers and signing contract Supply of product or service Use of product or service Specification Stage Sourcing Stage Utilisation Stage Preparation Stage Figure 1.5 - Traditional Procurement based on Witjes & Lozano (2016)

The problem with traditional procurement, is that the supplier selection is relatively late in the process. With traditional product or asset purchase, this is not an issue, mainly because the price is per product unit. But with PSS, the collaboration between procurer/purchaser and supplier is essential and the price will change to price for a service or function. Therefore, the traditional process no longer suffices.

Supplier Selection Stakeholder demand inventory and selection Procurer Supplier Definition of product or service Criteria specification Selection of suppliers and signing contract Supply of product or service Use of product or service Specification Stage Sourcing Stage Utilisation Stage Preparation Stage

Figure 1.6 - CE Procurement based on Witjes & Lozano (2016)

The procurement process which supports circular economy and PSS can be seen in Figure 1.6. Due to the increased dependence, the supplier needs to be involved earlier on in the process. This causes that the supplier selection needs to be earlier on. In order to properly select a supplier, the procurer needs to have clear selection requirements. The requirements should reflect the change from purely technical specifications to a collaboration of technical and non-technical specifications, combined with sustainability goals, such as disposal, resource usage, closing the loop and energy performance, from the procurer and the feasibility assumptions of the supplier regarding those goals (Aurich, Fuchs, & Wagenknecht, 2006) (Witjes & Lozano, 2016).

Value Suppliers’ business model Procurers’ business model Recovery

Raw Materials Waste

Collaboration Shared responsibility

Specifications Technical/non-technical

Figure 1.7 - Collaboration between Procurer and Supplier based on Witjes & Lozano (2016)

In the traditional procurement, specifications are determined by the procurer alone. With an more PSS oriented procurement process, the business model during procurement with product flow looks like Figure 1.7. Where there is close collaboration between supplier and procurer and that this leads to shared responsibilities as well as specifications determined together. This maximises the result, because the supplier can check whether it regards the (sustainability) goals of the procurer as feasible. Due to the changes in procurement, it can be concluded that the stakeholder involvement and management becomes much more important, due to the change of moment when a supplier becomes involved, as well as the increased dependency between both parties.

Best Practices

Within literature several best practices have been identified. These practices can help to better shape the transition towards PSS. The best practices are defined from a manufacturing point of view, but nonetheless, they can help to structure the thinking of a procurer, because it can help to steer and demand certain actions from their supplier. Pigosso & McAloone (2015) have provided a clear list of all best practices:

1. Develop a business model that can support the transition towards PSS

2. Create networks that foster innovation and promote customer resource integration 3. Define PSS offerings and value propositions to be provided to customers and stakeholders 4. Add service elements to the portfolio of offerings

5. Understand customer value creation processes to develop suited and specific value propositions

6. Co-create value together with the customers by developing service- and customer- oriented offerings

7. Identify available offerings in the market 8. Understand the life cycle of the offerings

10. Focus on value-driven communication of offerings – clearly communicate the value associated with the PSS offer.

11. Increase the extent of interactions with customers through the PSS offerings 12. Collect PSS data through increased interaction with customers

13. Align physical product characteristics with service offer characteristics and vice-versa 14. Identify preferable product properties to increase the value of the PSS business 15. Define the level of customization of the PSS offering

16. Assess strengths and weaknesses of the current product portfolio and markets

17. Identify the market value of the PSS compared to the competing product in term of tangible and intangible value

Decision making for a PSS value proposition

Compared to traditional asset valuation, a PSS consists of a tangible component, the asset, and an intangible component, the service component. To make sure that value is clear, the following definition is used (Rese, Karger, & Strotmann, 2009):

“Value is the worth in monetary terms of economic, commercia l, technical service and social benefit of customer’s firm receives in exchange for the price it pays for a market offering.”

However, the introduction of a service component in the valuation of an asset causes a new problem with valuation. How does one value a service component? The intangible part of the PSS is much harder to value and therefore it is more difficult for the customer to know if the price stated by a service provider is proper value for money, or not. This results in the problem that a value is needed for decision making, because as stated in Blauwdruk Assetmanagement (Asset Wise! Team Schiphol, 2015), Schiphol uses a TCO model to value alternatives on their monetary properties and it is a core component of the decision making process. Therefore, being able to value a PSS is important, if a fair and well comparison is to be made.

Before exploring how the value of a PSS can be determined, different valuation techniques will be treated. This to strengthen the understanding of the decision making process, as well as provide the tools for making the PSS valuation possible.

Net Present Value

One of the most well know valuation technique within project valuation is the Net Present Value (NPV) technique using Discounted Cash Flow (DCF). Using the NPV all future cash flows are taken into account and therefore a value can be determined. In order to capture all financial aspects of the life of an asset with regards for the influence of time on monetary value, discounting is used. The NPV is a wide spread method to value projects and can be calculated using the following formula (Brealey, Myers, & Allin, 2011) (Samis, Davis, Laughton, & Poulin, 2006):

𝑁𝑃𝑉(𝑖, 𝑁) = ∑ 𝐶𝑡 (1 + 𝑟)𝑡 𝑁 𝑡=0 where, 𝐶𝐹𝑡= 𝑁𝑒𝑡 𝐶𝑎𝑠ℎ 𝐹𝑙𝑜𝑤 𝑎𝑡 𝑡𝑖𝑚𝑒 𝑡 𝑡 = 𝑡𝑖𝑚𝑒 𝑜𝑓 𝑡ℎ𝑒 𝐶𝑎𝑠ℎ 𝐹𝑙𝑜𝑤 𝑟 = 𝑑𝑖𝑠𝑐𝑜𝑢𝑛𝑡 𝑟𝑎𝑡𝑒

𝑁 = 𝑛𝑢𝑚𝑏𝑒𝑟 𝑜𝑓 𝑝𝑒𝑟𝑖𝑜𝑑𝑠

The basic theory behind the NPV is that the project with the highest NPV should be accepted, because it adds the most value to a firm. If a project has a negative NPV is should be rejected, because it subtracts value from the firm. If the NPV would be zero, one should be indifferent between accepting or rejecting the project and decision making needs to be based on other criteria.

Expanding this to the perspective of the customer, e.g. Schiphol, the standard NPV valuation of a project at Schiphol is as follows (Rese, Karger, & Strotmann, 2009):

𝑁𝑃𝑉0= −𝐼0+ ∑ 𝐸𝑡 ∗ 1 (1 + 𝑊𝐴𝐶𝐶)𝑡 𝑁 𝑡=1 𝑤ℎ𝑒𝑟𝑒, 𝐼0= 𝐼𝑛𝑣𝑒𝑠𝑡𝑚𝑒𝑛𝑡 𝑎𝑡 𝑡 = 0 𝐸𝑡 = 𝐸𝑥𝑝𝑒𝑛𝑠𝑒𝑠 𝑎𝑡 𝑡 𝑊𝐴𝐶𝐶 = 𝑊𝑒𝑖𝑔ℎ𝑡𝑒𝑑 𝐴𝑣𝑒𝑟𝑎𝑔𝑒 𝐶𝑜𝑠𝑡 𝑜𝑓 𝐶𝑎𝑝𝑖𝑡𝑎𝑙 𝑜𝑓 𝐶𝑢𝑠𝑡𝑜𝑚𝑒𝑟

Within Schiphol, the Net Present Value technique is used to determine the Total Cost of Ownership (TCO). The TCO is in principle nothing else than an extended NPV where all costs and benefits over the life time of an asset or project are taken into account. This allows to capture the full value and make an informed decision about an asset over its complete (useful) lifetime. As stated in the current situation, Schiphol uses the Equivalent Annual Cost to transform the NPV to an annuity, in order to see what the cost per year would be.

The deficiency of a straight forward NPV analysis, is that risk and uncertainties are not captured. This problem can be overcome by several techniques and this is where the valuation of PSS will become more substantial.

Sensitivity Analysis

One of the best known techniques for checking uncertainties is sensitivity analysis. With sensitivity analysis, one checks what will happen if one of the parameters changes, or the assigned weight of a parameter changes. There are several parameters which can change during the course of an asset. Maintenance costs, replacement cost, energy, WACC, all can change during the lifetime of an asset and they all can have an effect on the value of a project. With sensitivity analysis, one parameter is changed and seen what kind of effect it has on the NPV. The limitation of sensitivity analysis is, that it only allows for one parameter to change. This limits the exploratory effect and it does not allow for the change of multiple parameters, therefore making it difficult to check on this effect (e.g. strengthening or dampening the effect of the changes). But it can give an idea of the sensitivity of the NPV to parameters.

Scenario Analysis

Another way of testing the NPV is by scenario analysis. Scenario analysis allows for multiple parameter to change according to the scenario specified. It calls upon the knowledge of the user to come up with possible or likely scenarios, both best and worst cases, which might occur and see what kind of effect it may have on the project valuation. It can therefore be considered more advanced than sensitivity analysis. The downside of scenario analysis is that every scenario must be thought of and implemented in to the NPV calculation in order to check it. This can be cumbersome and tedious work, especially if

projects are larger and more complex. Common scenarios often include, different interest rates, life span, residual value, replacement moments and maintenance costs.

Scenario analysis can be used in order to value PSS, because it allows to think about different states of an asset and which risks could occur (Sundin, Nässlander, & Lelah, 2015). This can then be used to make an assessment of what scenarios are possible for a supplier of a service and therefore assess which risks and uncertainties a supplier will be faced with. This can be used to explain why a supplier is offering a higher price, because it wants to be compensated for carrying the risks as were identified using scenario analysis.

Real Options

Real option (RO) theory is often presented as an alternative to the Discounted Cash Flow, or NPV, to value a project. Every project brings forth a number of options which might be executed in the future, or not. This managerial flexibility can be of great value, especially in the replacement or extra maintenance decision making. The parallel to the PSS and the traditional asset purchase and maintaining is easily made. Therefore, a part on Real Option Theory will contribute to a possible understanding and valuation of possibilities in the future.

The main difference between a NPV and a Real Option approach is that uncertainty in future cash flow and the risk which comes with it can be adjusted for, while in the NPV it can only be aggregated in the bigger picture, thus losing the flexibility or the ability to differentiate on the different risks involved. RO is able to distinguish between different options present in future time. Whether to irreversibly invest, or to postpone the investment (Santos, Soares, Mendes, & Ferreira, 2014).

Besides the difference, there are similarities between the DCF and the RO approach of valuing a project. Both see assets as uncertain cash flows received over a period of time. Both recognise that the value of an asset depends on the cash flow and it respective timing and summed gives the value of the asset, given the underlying assumptions. While the standard NPV approach uses one discount rate, in Schiphol’s case the WACC, to discount the cash flow for the appropriate risk and time, the Real Option approach uses a twostep approach.

Because every cash flow timing brings forth different risks, the first thing RO approach does is a risk adjustment. Each cash flow is adjusted for the its uncertainty, before it is discounted and added to the sum to value the respective asset. To put it more clearly, what RO does is valuing an asset as a portfolio of claims to individual cash flow elements and adjusting for uncertainty and the discounting for time (Samis, Davis, Laughton, & Poulin, 2006).

The problem with a Real Option approach, is that it is hard to make a proper assessment on the size of the cash flow. This allows for much noise to be added to the project valuation, which makes it hard to state that the estimate using Real Options is trustworthy.